The Optics of CEO Pay

Michael Jeffries, CEO of Abercrombie & Fitch Co., is regularly reviled in the press for the outsized salary he receives while his upscale store chain struggles. GovernanceMetrics International (GMI, formerly The Corporate Library), an independent risk and ratings group, named the company one of its 10 worst offenders in its November 2011 executive pay scorecard. Worse yet for Abercrombie’s board, Jeffries’ compensation package was nearly rejected by shareholders in last year’s say-on-pay vote, squeaking by with a 55.9% majority.

It is not tough to see why the firm’s investors were upset. Jeffries was paid $36.3 million in 2009, a year that saw tremendous downturns. Over the three-year period 2008-10, he reported $82.7 million according to proxy statements, more than twice as much as his counterpart at Limited Brands Inc., a comparable tony retailer that owns Victoria’s Secret and Henri Bendel, among other names, and used to own Abercrombie. The Limited has almost twice Abercrombie’s market capitalization, and its stock has risen more than twice as much over the past three years.

Jeffries’ benefits and perquisites alone came to $4.6 million in 2010. A portion of that, $4.0 million, was compensation for agreeing to amend his employment contract, which included personal use of Abercrombie’s corporate jet, the company’s general counsel, Ronald “Rocky” Robins Jr., says. So there has been plenty of focus on the issue of compensation in Abercrombie’s boardroom.

But hold up. Michael Jeffries is not just any off-the-rack CEO. Now 67, he is a retailing legend who took Abercrombie from near bankruptcy two decades ago to an iconic global brand worth some $4 billion on the stock market, founding the uber-successful teen sensation Hollister chain along the way. Jeffries’ previous employment contract expired in December 2008, during the depths of the recession and at a precarious moment when the board determined it could not afford to lose the firm’s leader. Robins explains the company was embarking on an “aggressive international expansion plan” at the time, and the board felt Jeffries’ leadership would “clearly benefit its long-term holders.” Therefore, Jeffries’ new employment contract was heavily weighted in performance metrics in order to lock him in for another five years, strategically rewarding him “if the stockholders benefited substantially more, as measured by an increase in market cap,” says Robins. Moreover, he states, the sizable equity comp numbers bandied about are primarily SEC-disclosure-based calculations of the Black-Scholes value of options that won’t vest until the new contract expires in 2013. Finally, he explains, these options don’t have any actual value unless the stock price increases above the grant date fair value of any award.

Comparisons with peer companies give further perspective on Abercrombie’s plan. Limited CEO Leslie Wexner, for instance, owns close to 20% of his company and has a Forbes-certified net worth of $3.2 billion. So arguably, Wexner doesn’t require the same salary as Jeffries. And yet, for those pointing the finger at Jeffries’ pay in the abstract, a more relevant peer comparison might be Apple’s new CEO, Tim Cook, who got a one-time signing bonus worth $383 million last August because the board deemed him the right man to receive the torch from the late Steve Jobs.

Robins says investors hopefully recognize that there are some companies in some industries where highly qualified CEOs are relatively interchangeable, and others, such as Apple in the tech sector and Abercrombie in retail, where the stockholders need to hire and then retain unique talent. “It’s a cookie-cutter world for evaluating executive pay,” says Robins. “But we’re not a cookie.”

All the same, Abercrombie fully understands the optics of the situation and is not deaf to shareholders’ concerns. The entire compensation committee that drew up Jeffries’ 2008 contract has since rotated (one member died) and new members have been brought in. And though the company admits that paying the CEO millions of dollars not to use the corporate jet was controversial, the board members believe this did allow them to put the perquisite issue largely behind them.

The situation at companies like Abercrombie vividly illustrates the conflicting pressures buffeting directors when they shut the boardroom door to hash out a new pay package for their chief executive and other top officers. Today, in order to deflect as much criticism as possible, part of that process must be to properly communicate a clear story for investors that justifies the board’s rationale. This is even more critical in a world where the risks and opportunities of tempestuous global markets make retaining and motivating the top person in the organization more important—and in many cases, more expensive—than ever. Recent data bears out this trend.

According to GMI, median CEO pay in the Standard & Poor’s 500 rose 13% in 2010 after subsiding a bit in 2008-09.

Thus, transparency, a restive public, and say on pay engender an unprecedented risk of embarrassment, not to mention derivative shareholder lawsuits, for boards perceived to be overpayers. While boardroom insiders may be tempted to pat themselves on the back since just under 2% of say-on-pay votes came back negative during the first season in which they were mandatory under Dodd-Frank, the ranks of “maybe on pay,” companies garnering less than 70% shareholder approval, are many times larger: 157 in the Russell 3000 index fall into this category.

Observers note that the story may be more worrisome this year. After 2010, when S&P 500 stocks gained just over 10%, investors were more inclined toward generosity. However, the S&P was pretty much flat in 2011, promising a more cantankerous proxy season in 2012, experts warn. “There is going to be a different atmosphere this year,” says Irv Becker, leader of consultant Hay Group’s U.S. executive compensation practice. “I think you are going to see a lot more companies having issues with say on pay.”

As CEO employment contracts grow simultaneously richer, more intricate, and more visible, disputes about them become more heated. Many of the consultants who help boards design pay packages find themselves at odds with Institutional Shareholder Services, the top proxy adviser whose recommendations to big investors are influential but not decisive in say-on-pay votes. The pay gurus complain bitterly about ISS’s allegedly rote approach that fails to look deeply enough into individual company circumstances.

“I agree entirely that ISS has done more harm than good over the past year,” says Frank Glassner, CEO of Veritas, a California-based comp consultancy. “Their algorithms are flawed.” Only about half of the no recommendations last season were justified, he estimates.

Carol Bowie, director of compensation policy development at ISS, not surprisingly, begs to differ. ISS researchers did red flag the pay schemes of more than 800 companies last season based on mathematical comparisons of pay and stock market performance relative to an industry peer group. But each of these was then studied in a “qualitative” way, and less than a quarter of them ultimately received “no” vote recommendations, she relates. Around 100 companies earned an ISS “no” call based on particular “problematic pay practices” on severance and other awards not linked to performance. Bowie dismisses attacks on ISS from the corporate side as scape-goating. “We make a convenient target,” she says.

With this sort of rancor in the air, it is useful to take a deep breath and observe that all sides in the CEO compensation debate actually agree on a number of key points. First, most agree there is no problem with chief executives getting rich so long as they make their shareholders richer. Much of the general public may be upset by the impressive raw numbers on CEO pay. But investors with skin in the game, and investor watchdogs, don’t mind paying for performance.

Second, most agree a large majority of U.S. public companies do get it basically right in gearing the boss’s rewards to how well he or she generates profit and share growth. “Most people understand that a majority of CEOs are doing a good job,” says Paul Hodgson, chief of research at GMI. “The negative perception is based on a few cases where they are massively overpaid.”

Third, there’s little disagreement about the fact that there is nevertheless a minority of corporate laggards where pay in the C-suite aligns poorly with productivity. Ira Kay, a managing partner at consultant Pay Governance, rails against ISS’s supposedly simplistic reliance on “pay opportunity”—the future value of current share and options grants estimated in the corporate proxy statement based on the well-known Black-Scholes method and other academic alchemy. He proposes an alternative yardstick that he calls “realizable pay,” which calculates the actual value of outstanding options and share grants at current market levels—meaning, among other things, that options count for zero if company stock is trading below the grant or “strike” price.

But even by this metric, Kay estimates that about 20% of all companies have less than stellar pay/performance correlation. That is worse than ISS itself, which recommended “no” votes at 13% of the firms it scrutinized in 2011. Competing proxy adviser Glass Lewis is a harsher critic, turning thumbs down at 17% of the companies it studied.

Yet, while no one is saying it’s the perfect answer, the concept of realizable pay is one that is catching on in many circles. Bob Romanchek, senior partner and adviser, Meridian Compensation Partners LLC, subscribes to the notion that realizable pay should be captured in regularly updated tally sheets covering executive officers because it will help provide boards the basis for being “fully informed” for the purposes of the business judgment rule, particularly for long-term incentive compensation.

“Looking at realized pay also provides a relevant benchmark for determining if your incentive programs are actually working and to determine if you have aligned pay for performance over a number of years,” Romanchek says.

He notes that one area of confusion in this area often occurs by virtue of the fact that the proxy disclosure mixes the concepts of realized versus unrealized pay opportunities (i.e., cash compensation is reported as realized, whereas equity-based long-term incentive opportunities are reported as an estimated value at the date of grant).

“Since you don’t know what will be realized in the future with a long-term incentive opportunity, you need to be able to translate this into a current dollar equivalent if you have the task of measuring total pay competitiveness at any single point in time,” he explains. “Using either an economic value or a realized pay translation could both be of use; however, neither approach is perfect, and neither should be considered in a vacuum as the end-all solution.”

In general, both sides of the aisle agree that companies need to keep pushing away from guaranteed largesse to CEOs, particularly fat severance payments and perks, and toward rewards linked to more demanding performance criteria. How to structure that pay for performance is the subject of lengthy debates that can frequently turn unfathomable to the nonspecialist, with arcane calculations of “overhangs” and “burn rates.” But the basic commitment seems widespread. “People don’t think you should get the money just because you’re there,” Hay Group’s Becker concludes.

Or, even more to the point, because you are not there anymore. The first year of compulsory say-on-pay votes shows that nothing will provoke investors’ ire like a golden parachute for a CEO on his or her way out. Take Pfizer Corp., for example.

Long viewed as a paragon of corporate governance, Pfizer voluntarily offered its shareholders a say-on-pay vote in 2010 and won 96.8% approval. Yet last year, that percentage sank to 55%, one of the closest approval shaves in corporate America. What happened? The difference seems to have stemmed from a $16 million severance package for departing chief executive Jeffrey Kindler. This expensive farewell was not part of Kindler’s original contract, according to a review by GMI, but rather it was simply a mark of appreciation from the board upon retirement, leading to a “no” recommendation by ISS, with shareholders following suit. Pfizer declined to comment, but in its 2011 proxy filing, it defended the measure by stating:

“We strongly disagree with this recommendation. ISS’s position appears to be based entirely on its opposition to the separation arrangement with our former Chief Executive Officer…. Our Board believes that the arrangement was in the best interests of our shareholders, in part because it provided significant non-competition, non-solicitation, and other protections to the Company. In addition, the amounts paid and to be paid under the arrangement were largely based upon the terms of our plans and programs applicable to other executive officers.”

Another twist on the say-on-pay story involved outraged shareholders at Stanley Black & Decker Inc. The well-known toolmaker earned the distinction of having the worst say-on-pay outcome in the S&P 500, with less than 38% in favor, despite strong operating results and a general compensation scheme that receives high marks from watchdog GMI. The contentious issue was the pay package for Nolan Archibald, the former CEO of Black & Decker who stayed on in an executive chairman’s role after the merger with Stanley in 2009. Despite not running the company day-to-day, Archibald, now 69, was slated for compensation valued at $26 million in 2010 and $43 million in 2011. That is in addition to a $45 million bonus for merger synergies due in 2013. Stanley has declined to comment on the vote and did not return requests for comment.

In the face of such daunting opposition, and the negative trail of publicity that follows these situations, other companies are taking heed and trimming their own parachutes, surveys indicate. An annual study by consultant Pearl Meyer & Partners shows 12% of companies polled proactively reduced severance pay for CEOs (except for change-of-control situations) in 2011, with another 9% saying they expected to prune sometime in 2012.

A particular target related to parachutes is the device known as “excise tax gross-up,” which means the corporation will make up to the departing executive the federal government’s 20% windfall tax on “excessive” payments. While not a make-or-break item on a corporate balance sheet, tax gross-ups are a cause célèbre for ISS, one of the problematic practices that warrants an automatic “no” recommendation, Bowie says. Accordingly, they are going the way of the dodo. About 70% of corporate America employed them in 2007, according to BusinessWeek, yet the Pearl Meyer survey found that level had dropped to 35% in 2010 and is predicted to drop much further in fiscal year 2012.

Boards are nibbling more delicately at other executive perquisites, despite their potential for generating bad publicity. Out of 347 U.S. companies polled last year for an annual survey by Hay Group and the Wall Street Journal, just 10 took the bold step of axing the CEO’s country club membership. Personal use of the corporate jet also remains typical; 61% of corporations allow it for their top exec.

Other, more basic compensation challenges surround the means by which pay is calculated. The large majority of most chief executives’ pay these days comes in the form of long-term incentives (LTI), a mix of company shares and options granted today, but paying out sometime in the future. LTI generally comes in one of three forms: restricted stock awarded to the CEO in a fixed quantity; options; or “performance shares,” whose number depends on how well the recipient met various targets in the grant year. The appropriate mix and scope of these instruments remains something of a black box for directors, starting with how much a given grant is really worth.

The standard valuation of LTI that appears on proxy statements and also in the popular press is derived from pay opportunity, the future value estimate of current grants. This calculation is dictated by standard accounting procedures and SEC regulations. But, as Graef Crystal, the compensation scholar and longtime Bloomberg News columnist once wrote, it’s still a “wild-ass guess” on what the executive in question will really earn in the end. Therefore, compensation consultants are beginning to rally around the realizable pay standard.

Pay Governance’s Kay claims that many companies pilloried by ISS for overpaying their CEOs would look better using the realizable pay metric. He combed through the reports of 374 large corporations over three years, 2008-2010, and found that realizable CEO comp was 54% higher at better-than-average market performers than at worse-than-average ones. (Bottom 50-percentile CEOs still held an average of $12.3 million in LTI for overseeing an average 8% share decline, though.)

To proxy advisers and shareholder watchdogs, Kay’s argument smacks of tautology. It’s hardly surprising that stock options and grants are worth more in the aggregate at companies whose stock has been rising, GMI’s Hodgson observes. But Kay’s calculation overlooks the underperforming company that heavily rewarded its CEO this year or last. On the whole, however, most governance observers seem to agree that chief executive pay is reasonable on average. “We can and do argue all day at conferences about the appropriate methodology for pay/performance alignment,” says David Eaton, head of proxy research at Glass Lewis. “The idea is to find the outliers, no matter how you calculate.”

With thousands of companies out there for investors to evaluate, the concept of pay opportunity also has the distinct advantage of being a standard that “compares apples to apples” at a glance, ISS’s Bowie adds.

Beyond this abstruse accounting debate, though, there are signs that the two sides are paying attention to each other. Two corporate icons, Walt Disney and General Electric, seem to have listened to ISS directly last proxy season, changing compensation policies after a “no” recommendation from the adviser. Disney eliminated excise gross-ups in the severance packages of CEO Robert Iger and other “named executives” on the proxy, something of a slam dunk given the consensus against these arrangements.

GE’s shift touched on a subtler and more far-reaching issue. It put performance conditions on 2 million stock options that chief executive Jeffrey Immelt was to receive regardless of the company’s results. Half will now vest only if the company’s total shareholder return at least matches the S&P 500’s between 2011 and 2014; the other half are based on corporate cash-flow targets.

GE’s move is one indication that proxy advisers are making headway in their campaign to curtail “free” stock options as a centerpiece of CEO compensation.

This stance might seem strange after a generation when everyone seemed to agree that options are a good way to align the long-term interests of managers with that of shareholders. All the same, both big advisers have mostly soured on them.

“We don’t consider stock options to be a vehicle that is tied to long-term company performance,” Glass Lewis’s Eaton says. “Their performance is totally dependent on the ups and downs of the stock market.”

Indeed, stock options seem to be losing some ground in the average pay package to performance shares, says Hay Group’s Becker. Hay’s most recent survey showed performance shares rising to 41% of CEO long-term incentive pay during 2010 from 37% a year earlier. Options slipped to 34% from 39%. The reason: “It turns out performance shares are the vehicle that is most leveraged to returns,” Becker says. “The grant itself depends on reaching certain targets, and then the profit depends on the rise in stock price.”

Time-vested restricted shares, the third leg of the increasingly popular “portfolio approach” to executive comp, meanwhile, held steady at 25% of the average package. And the guaranteed share figures remain an important retention tool, Becker notes.

So what does an ideal CEO compensation plan look like? GMI sings the praises of Seattle-based retail chain Nordstrom Inc. Its chief executive’s headline pay came to $5.9 million in the growth year of 2010, surprisingly lean for a $10 billion market-cap company. The boss earned just $1.9 million in 2008, suffering (relatively) along with his shareholders. The perk line even in 2010 was held to just $63,852. More than 75% of the package is “linked to objective financial or market targets,“ a company spokesman says.

There is one catch, though. The name of Nordstrom’s CEO, or president as the company prefers, is Blake Nordstrom. Two of the other four officers named in the proxy are also Nordstroms. The family jointly owns about 25% of the company and so arguably, does not really need much extra incentive to look after its investment.

Which gets back to Robins’ point about Abercrombie & Fitch: Every company really is unique, and facile comparisons may crumble on closer scrutiny. The one thing for sure is that scrutiny of CEO pay is only getting more intense. More boards will be called upon to fight their own instincts for confidentiality and explain, at least to shareholders, how they justify all those dollars they are paying out. “Professionals can come up with good statistical support for any position they take on pay,” says Gary Lutin, chairman of the nonprofit Shareholder Forum. “What they need to focus on a lot more is making sure their constituency understands it.”

In the end, this is a story about optics and how much they matter. And communicating the board’s story is going to take on more relevance as the pendulum continues to swing toward greater transparency and more intense calls to action on the part of shareholder activists and investors at large.

Meridian’s Romanchek agrees proper communication should not be underestimated. “Beyond making simple common sense, you now have the influence of a number of external market elements to ensure that proper focus is placed on clearly articulating to shareholders your compensation story.” Specifically, he notes, in its new pay for performance alignment test, ISS has identified “the completeness of disclosure” as one of its formal qualitative factors in determining whether practices either encourage or undermine long-term value creation and alignment with shareholder interests. “This will directly impact whether ISS will recommend a yes or no vote on say on pay,” Romanchek states. In addition, he says plaintiffs’ counsel are becoming more active in situations where they perceive a pay-for-performance disconnect—even when a majority vote has been obtained. “If the full pay-for-performance story is clearly articulated, these lawsuits may be avoided,” he says.

Thus, boards would be well advised to pay close attention to the story they are communicating in the months ahead. No matter what the rationale behind your boards’ comp decision, the optics may save the day.

About Craig Mellow

I can't do much about peace and love. But I will try to do my bit for understanding - markets and the people behind them. It's the greatest work in the world.